Wednesday, February 25, 2009

Gold Reigns Atop the Great Divide

By LIAM DENNING
Goldbugs and their similarly intense brethren, the "peak oilers," appear to have had a falling out.
Their apocalyptic visions of crude shortages and economic and political chaos helped prices of both oil and gold surge in recent years. Since early November, however, they have diverged, with New York Mercantile Exchange crude down more than 40%, and gold up by much the same amount.
It is becoming clear that in this particular Armageddon, two things are happening: Governments are printing money, and people and factories are burning less oil.
Even with oil now below $40 a barrel and gold nudging $1,000 an ounce, this "schism spread" could continue widening for some time. Gold demand, normally weighted heavily to jewelry, is now driven by investors. Retail buyers, in particular, lacking easy access to more sophisticated inflation hedges, have piled into gold exchange-traded funds.UBS metals strategist John Reade points to a collapse in gold leasing rates, the cost of borrowing gold, since November. That can be interpreted as a positive sign. In particular, speculators that might be tempted to sell gold short in anticipation of a price fall must contend with a fear that the financial system will unravel or the cost of government backing for the economy will mean higher inflation further down the road.
In one respect, that reliance on investment demand should make speculators nervous: Once fear of inflation subsides, the ETFs' vaults might empty quickly. Inflows have slowed this week. That could prove temporary, however. The amount of money invested in gold ETFs is a fraction of the trillions lying in U.S. money-market funds. A small switcht would underpin further increases in prices.
As a dollar-denominated commodity, oil also ought to do well as the Federal Reserve prepares to flood the system with money. Against that, however, retail investors, having seen the oil price drop precipitously, will tend to choose yellow gold over the black variety.
Unlike gold, oil's transformation into a popular asset class is a relatively recent phenomenon. Its price is ultimately tied to how much we are burning.
On that front, there is little to cheer energy bulls. The International Energy Agency now expects global oil demand to drop a total of 1.5% across 2008 and 2009. That would be the first two-year decline since the early 1980s. But in terms of magnitude, it would be closer to the recession of the early 1990s.
Given the seriousness of the current recession, the impact on energy demand probably will be deeper and longer lasting than the IEA envisions.
Where the current economic downturn bottoms out is anyone's guess, but it is clear governments want to print their way out of it. Such crude logic favors gold.
Write to Liam Denning at liam.denning@wsj.com